Currency Strategy A Practitioner s Guide To Currency Investing Hedging And Forecasting Wiley_5 pdf

128 Currency Strategy
warning of the reversal to come. This is indeed what happened with the zloty and the yen.
We looked at this phenomenon briefly in Chapter 2. Here, in the context of a chapter devoted
specifically to exchange rate models, we do so in considerably more detail. While this can be
applied to developed market currencies, there are specific considerations with these such as
“safe haven” and “reserve currency” status, which distort all models. This particular model
is particularly effective with freely floating emerging market currencies, given how capital
inflows influence nominal and real interest rates. In the case of the CEMC model, we used
the example of Thailand to demonstrate it in practice. With the freely floating exchange rate
model, specializing in emerging markets, we use the example of Poland.
6.2 A MODEL FOR FREELY FLOATING EXCHANGE RATES
6.2.1 Phase I: Capital Inflows and Real Exchange Rate Appreciation
Theory
Under a pegged exchange rate, capital flows are attracted by the perception of exchange
rate stability created by the peg itself. Conversely, under freely floating exchange rates, such
capital flows are attracted by the prospect of high returns, either of income or capital gain.
Fundamental flows are attracted to a currency, attracted both by currency and underlying asset
market-related valuation considerations. Such capital inflows force the currency to appreciate
and simultaneously force nominal interest rates lower. As a result, during this period, the
correlation between the asset markets and the currency increases. Capital flows lead to both
nominal and real exchange rate appreciation.
Practice
During much of 2000, the National Bank of Poland tightened monetary policy by hiking interest
rates to squash inflation. Towards the end of that year, with the NBP’s 28-day intervention rate
having peaked at around 19%, nominal and real interest rates peaked, as did inflation. The result
was irresistible to fixed income investors, attracted both by extremely high interest yields and
the prospect of capital gains. As the NBP began cautiously to relax its monetary policy, this
triggered an increasing tide of capital inflows. Asset managers reduced or even eliminated
their currency hedges. Dedicated emerging market investors raised their asset allocation in
Polish bonds, while cross-over investors increased their exposure to what was an off-index
investment.

6.2.2 Phase II: Speculators Join the Crowd — The Local Currency Continues to Rally
Theory
Most speculators, though admittedly not all, are trend-followers. Thus, the longer the fun-
damental trend continues, the more trend-following speculators are attracted to what seems
risk-free profit and thus ultimately the more speculative the trend becomes. As the exchange
rate continues to appreciate, nominal interest rates to decline and capital inflows to continue,
so the other side of the balance of payments starts to deteriorate. The balance of payments
must balance and therefore including errors and omissions, a rising capital account surplus
must be offset by a widening current account deficit. Equally, real exchange rate appreciation
Model Analysis 129
must lead to external balance deterioration. For now, the deterioration is not sufficient to cause
concern among fundamental investors and is more than offset by speculative inflows, thus the
trend becomes self-fulfilling as more and more speculators join the trend.
Practice
From October 2000 through March 2001, Polish bonds roared higher, benefiting from cuts in
official policy interest rates in response to clear signs of slowing economic activity within the
Polish economy. The dollar–Polish zloty exchange rate, which at one time had been as high as
4.75 extended its downward trend, at one point breaking through the 4.00 barrier. More and
more leveraged money funds sold US dollars or Euro and bought zloty on the back of this move.
For a time, “real money” asset managers did the same, increasing their currency exposure as
a result of their buying of Polish bonds. There was no incentive to hedge that currency risk.
Indeed, there appeared to be every incentive not to hedge — the high cost, the appreciating
trend in the zloty and the desire to keep the carry of the original investment (which hedging
would reduce or even eliminate).
6.2.3 Phase III: Fundamental Deterioration — The Local Currency Becomes Volatile
Theory
Fundamental investors and speculators do not necessarily sit easily together. They have dif-
ferent investment aims and parameters, the first looking for regular investment capital gain or
income over time, the latter looking frequently for short, quick moves. Granted, this is a gross
exaggeration and generalization, but it gives at least something of a flavour for the different

dynamics at work between the two investor types. The longer the trend continues the more
speculative it becomes in a number of ways. In the first case more and more speculators join
the trend, sure of easy money to be had. Equally, however, the longer this trend appreciation
goes on, the more damage it does to the external balance and thus the more speculative it
becomes in the sense of not being fundamentally justifiable. Real exchange rate appreciation
must lead to external balance deterioration. Indeed, fundamental market participants, such as
asset managers and corporations, increasingly reduce their currency risk for the very reason
that there are such fundamental concerns. The ability of speculative inflows to offset funda-
mental outflows from the currency is increasingly reduced. Because of this increasing tension
between fundamental and speculative flows, option implied volatility picks up in the face of
increasingly choppy and volatile price action.
Practice
From March through mid-June 2001, the Polish zloty continued to appreciate, albeit in an
increasingly erratic and volatile manner. Frequent sell offs would be followed by sharp rallies.
Asset managers became increasingly aware of the degree of slowdown in the Polish economy.
While this should conversely be good news for fixed income investors as it caused inflationary
pressures to decline further, it was a source of increasing concern for equity investors. The
market’s overall appetite for risk remained relatively high, helped in large part by continued
monetary easing by the Federal Reserve. Further, the National Bank of Poland was also cutting
interest rates, albeit cautiously in the face of clear evidence of abating price pressures. However,
130 Currency Strategy
both the pace and extent of zloty strength were a cause of concern to investors, and it seems
also to the Polish government. Ahead of elections in September (in which it was subsequently
routed by the opposition SLD party), the AWS-led government was increasingly desperate to
boost the flagging economy, whether by interest rate cuts, fiscal expansion or a weaker zloty.
Markets feared a change in exchange rate policy, either by the existing government or more
likely by the opposition, which looked increasingly likely to win the election and in the end did
indeed do so. Around June, given the gains seen by then in both Polish bonds and the currency,
a combination of market concerns over fundamental deterioration in the economy, notably in
the trade balance, and over the prospect of a likely SLD election victory in September triggered

increasing interest by investors, particularly offshore investors, to take profit on those gains.
6.2.4 Phase IV: Speculative Flow Reverses — The Local Currency Collapses
Theory
The tension between speculative inflows and fundamental outflows continues to increase,
causing violent price swings, until such point as those inflows are not sufficient to offset the
rising tide of outflows. Like an inventory overhang that seems to appear out of nowhere in
the wake of over-investment, the result is a supply–demand imbalance in the exchange rate.
Demand collapses in order to restore equilibrium. In this case, that means a sharp reversal
of speculative inflows, which are by nature more easily and more quickly reversed than their
fundamental counterparts. Markets overshoot on both the upside and the downside, which
means that the correction in the exchange rate to offset over-appreciation is likely to exceed
what fundamentals suggest is required. Eventually it manages to stabilize again, starting off
a new round of appreciation as fundamental inflows are attracted anew. The sharp correction
in the exchange rate should help restore lost trade competitveness. Just as real exchange
rate appreciation must lead to external balance deterioration, so the cure for the latter is real
exchange rate depreciation. This can happen either through nominal exchange rate depreciation
or through a sharp fall in inflation. The easiest and most efficient way for this to happen is
through the former. Once that correction or nominal depreciation happens however, the external
balance should respond positively.
Practice
At the June 27 FOMC meeting, the Federal Reserve cut interest rates by 25 basis points as
expected. Notably, risk appetite indicators did not improve in the wake of this, the first time
all year that Fed monetary easing had failed to boost risk appetite. In hindsight, this should
have proved a major warning signal, and not just for the Polish zloty but for global financial
markets as a whole. A week later, the tremors of the earthquake to come were starting to be
felt. On the Thursday, the dollar–zloty exchange rate was already heading higher, boosted by
profit-taksing on long zloty positions by asset managers and by a lack of fresh demand for
zloty from this quarter. Having bottomed out at around 3.92, dollar–zloty broke back above the
4 level to retest 4.10. Come Friday morning, dollar–zloty broke above 4.20, then 4.25 and then
it broke above 4.30. Speculative money that had been long zloty, both against the US dollar

and the Euro, either decided to close out their long zloty positions or were stopped out of them.
Despite fundamental outflows, there were still asset managers who had substantial positions in
Polish bonds and most of these were unhedged from a currency perspective. The spike higher

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Model Analysis 131
in Euro–zloty and dollar–zloty forced these to currency hedge their bond positions, in the pro-
cess greatly accelerating the move. Dollar–zloty leapt forward, screaming through 4.40, 4.45,
4.50, only peaking out at around 4.55. In the first six months of 2001, the zloty appreciated by
around 10% against its old basket value, only to lose that and more in two days in July. From
a peak of around +15.5% against its basket, the zloty fell to as low as +2.5% before finally
managing to stabilize. The fall provided a major competitiveness boost to Polish exporters,
who quickly took advantage of the opportunity to hedge forward by selling US dollars and
Euro against the zloty at such elevated levels. In this way, fundamental buyers returned to both
the zloty and to the Polish asset markets, in the form of corporations on the one hand and
investors on the other. The cycle began again. Over the next six months, the zloty appreci-
ated from +2.5% to over +14% before again correcting, this time to around +6.8% before

stabilizing.
Thus, where we have the CEMC model for pegged or fixed exchange rates, the speculative
cycle model can be used for floating exchange rates. Readers will of course note that these two
models have been used in the context of emerging markets. The dynamics of the developed
currency markets are slightly different in so much as they are much more liquid and therefore
the transmission from portfolio flows to currency strength is less immediate. Equally, very few
developed market currencies are pegged — indeed one could argue that the very act of moving
from a pegged to a floating currency is itself one necessary aspect of progression from emerging
to developed country status. Thus, while the CEMC is not of much use for developed market
exchange rates in this context, the speculative cycle model can be used for both emerging and
developed exchange rates.
One should note however that the time period over which speculative cycles last in the
developed exchange rate markets can be significantly longer — years rather than months —
than is the case in the emerging markets. This is so because developed exchange rate markets
are substantially more liquid, but more importantly because the size of capital flows has such a
disproportionately larger impact on the real economy of emerging markets than is the case with
developed economies. Capital flows that can have only a lasting impact on the real economy
of a developed market after a substantial period of time are so large by comparison with the
size of an emerging market economy that they have a much more significant impact.
If we look at what happens within the developed exchange rates, the speculative cycle of
exchange rates also has major relevance, with the proviso that it takes place over a much
longer period of time. The starting place for developed market exchange rates is of course
the US dollar. If we examine the performance of the US dollar from 1991 to 2001, we can
indeed see the speculative cycle of exchange rates at work. Roughly speaking, from 1991 to
1995, the US dollar was in a clear downtrend. Initially, this was due to fundamental concerns,
both of valuation and of growth prospects. The Gulf War in 1990–1991 gave way to a deep
if brief recession in 1991–1992. From 1993, this was exacerbated by the market’s increasing
view that the new Clinton administration had a deliberate policy of devaluing the US dollar
in order to boost US export competitiveness and reduce the US trade and current account
deficits, particularly against Japan. While US officials now say that this was never the case,

at the time US officials made repeated statements that could easily have been interpreted as
such, suggesting the US wanted a weaker currency. Fundamental investors increasingly sold
their US assets during 1991–1993, and during 1993–1995 this process increased despite US
economic recovery on the view that the US was deliberately devaluing the dollar. Eventually, as
these things tend to do, this fundamental selling attracted the attention of the speculators, who
also started to sell en masse. The speculative pressure grew and grew, causing the US dollar
132 Currency Strategy
to fall in value against all of its major currency counterparts, such as the Japanese yen and
the German Deutschmark. This increasingly happened as the fundamentals of the US were
starting to improve, helped in large part by the dollar depreciation that had reduced that US
trade deficit by making US exports more competitive. Fundamental investors started to get
back into US assets, however the speculators, attracted even more by irresponsible US official
comments on the currency, were still selling. Eventually, the patience of the US authorities
snapped and the Federal Reserve intervened on several occasions in 1995 to stem the tide of
speculative selling. The current Undersecretary of the US Treasury Peter Fisher was at the
time the head of open market operations at the New York Fed and therefore responsible for
the Fed’s intervention in the foreign exchange markets. Fisher explained the Fed’s aim not so
much as to defend a specific currency level or to of necessity stop a currency from weakening,
but rather to intervene in order to recreate a sense of two-way risk in the markets.
2
The Fed
uses a number of market pricing indicators to tell whether or not two-way risk — the risk that
a currency can go up or down — exists and most if not all of these were at the time suggesting
that the market viewed all the US dollar risk as being to the downside. The Fed’s intervention,
carried out in conjunction with the Bank of Japan and also with monetary policy change by
the BoJ, helped cause a sea-change in market sentiment. The US thus achieved what they were
looking for, two-way risk in the dollar. In the wake of this, the fundamental buyers increased
significantly in number and the speculators reversed and also started buying.
Thus, the speculative cycle worked, albeit with somewhat of a delay due to the view that
the US was deliberately trying to devalue its own currency. From 1995, the US dollar thus

has been on a trend of appreciation, more than reversing the weakness seen in 1991–1995.
Readers will of course be aware that the speculative cycle works both ways, when a currency
is appreciating and also when it is depreciating. Thus, the US dollar strength that we have seen
since 1995 has indeed caused fundamental deterioration. If the speculative cycle holds up, the
speculative buying will be overwhelmed by the fundamental selling by asset managers and the
US dollar will reverse sharply lower. The warning sign for that to come will be when we see a
sharp spike in options volatility without any major moves in the spot market, reflecting major
flow disturbance in the market as the fundamental selling pressure intensifies.
In recent years, the economic community has developed a very large number of exchange
rate models for analysing currency crises, and it is certainly not for here to repeat a list of
them. That said, they can be classified into three broad categories of currency crisis model.
First-generation crisis models focus on the “shadow price” of the exchange rate; that is the
exchange rate value that would prevail if all the foreign exchange reserves were sold. These
models generally view as doomed a central bank’s efforts to defend a currency peg using
reserves if the shadow price exchange rate is in a long-term uptrend. It is assumed that rational
speculators will immediately eliminate a central bank’s foreign exchange reserves as soon as
the shadow price exceeds the peg level. A key feature of first-generation currency crisis models
is that they generally see currency crises as being due to poor government economic policy;
that there was a degree of blame involved, that poor government policy caused the currency
crisis.
Unlike with the first-generation model, second-generation crisis models do not see a cur-
rency crisis as being due to poor government economic policy, but instead due to the currency
peg being at an uncompetitive level. The main inspiration for second-generation crisis models
2
As explained by Peter Fisher at the quarterly meetings at the New York Federal Reserve to discuss foreign exchange activity,
1995.
Model Analysis 133
was the ERM crises of 1992–1993. In 1992, the UK was not willing to take the economic
pain required to keep their peg of 2.7778 against the Deutschmark. In August 1993, most of
continental Europe was forced to abandon their 2.25% bands. However, instead of allowing

their currencies to float freely, they widened the 2.25% band to 15%, a compromise solution
between a full flotation and a pegged exchange rate. In the cases of the UK and of continental
Europe, the de-pegging of the exchange rate did not cause the much anticipated economic
recession. Indeed, the cost of defending the peg was very high interest rates, thus hurting the
economy. With the currency pegs gone, there was no longer any need for such high interest
rates. Thus, the de-pegging of the exchange rate was on the one hand due to the government’s
unwillingness to take the economic pain needed to defend the peg, but on the other hand that
pain was due to an uncompetitive exchange rate peg level. For the UK in particular, the de-
pegging of sterling, which came to be known as “Black Wednesday”, was the best thing that had
happened to the UK economy for several years. Interest rates are lowered and exchange rates
stabilize at a much more competitive and appropriate level when currency pegs are broken,
according to second-generation models.
Third-generation currency crisis models, which developed in the wake of the Asian cur-
rency crisis, involved “moral hazard”, that is the idea that private sector investment in a specific
country will result if a sufficient number of investors anticipate that country will be bailed out
by multinational organizations such as the IMF. Inward investment and external debt rise in
parallel as a country continues to be bailed out until such time as the situation is untenable.
The currency is one main expression of that situation’s collapse.
With the first-generation currency crisis model, the focus is on blaming poor government
economic policy, particularly poor fiscal policy. With the second-generation model, the issue
of blame is less clear and the focus is more on an uncompetitive exchange rate rather than poor
government economic policy. For its part, the third-generation model focuses not on the reason
for the currency crisis but the result, or more specifically the massive real economic shock that
came from “moral hazard” investment caused by the combination of currency devaluation
and external debt. Put simply, second-generation models can be “good”, but third-generation
models are unequivocally “bad”.
6.3 SUMMARY
In Chapter 5, we looked at how the type of exchange rate regime can affect currency market
considerations. Here, in Chapter 6, we have tried to extrapolate this, looking at currency models
for fixed and floating exchange rate regimes. While the aim of both chapters has been to show

the practical aspects of these themes, the methodology has largely been theoretical rather than
practical, that is the focus for the most part has been on the theory of how exchange rate
regimes affect economic behaviour and equally the theory of how currency crises develop.
In the next three chapters however, we take an entirely different line, focusing on practice
rather than theory, looking at how the practitioners themselves can use currency analysis and
strategy to conduct their business. We start this process by off by looking at how multinational
corporations might seek to manage their currency risk.

Part Three
The Real World of the Currency
Market Practitioner
Market Practitioner

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7
Managing Currency Risk I — The

Corporation: Advanced Approaches to
Corporate Treasury FX Strategy
The management of currency risk by corporations has come a long way in the last three decades.
Before the break-up of Bretton Woods currency risk was not a major consideration for corporate
executives, nor did it have to be. Exchange rates were allowed to fluctuate, but only within
reasonably tight bands, while the US dollar itself was pegged to that most solid of commodities,
gold. The responsibility for managing currency risk, or rather maintaining currency stability,
was largely that of governments. Needless to say, that burden, that responsibility has now
passed from the public to the private sector.
This chapter deals with the corporate world, how a corporation is affected by and how
corporate Treasury deals with the issue of currency or exchange rate risk. More specifically,
this chapter will look at:
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Currency risk — defining and managing currency risk
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Core principles for managing currency risk
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Corporate Treasury strategy and currency risk
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The issue of hedging — management reluctance and internal hedging
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Advanced tools for hedging
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Hedging using a corporate risk optimizer
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Advanced approaches to hedging transactional and balance sheet currency risk
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Hedging emerging market currency risk
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Benchmarks for currency risk management

r
Setting budget rates
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Corporations and predicting exchange rates
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VaR and beyond
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Treasury strategy in the overall context of the corporation
In short, there is a lot to cover. This chapter is aimed first and foremost at corporate Finance
Directors, Treasurers and their teams. In addition, it attempts to give corporate executives
outside of the Treasury a greater understanding of the complexity and difficulty entailed and
the effort required in managing a corporation’s exchange rate or currency risk. As we shall see
later in the chapter, many leading multinationals have set up oversight or risk committees to
oversee the Treasury strategy in managing currency and interest rate risk. This is an important
counter-balance for the corporation as a whole, but of course it requires that the committee
itself is as up-to-date with the latest risk management ideas and techniques as are the Treasury
personnel themselves.
The way the corporation has dealt with currency risk has changed substantially over time.
Corporations, many of which were reluctant to touch anything but the most vanilla of hedging
structures, have now greatly increased the sophistication of their currency risk management
138 Currency Strategy
and hedging strategies, particularly over the last decade. In this regard, two developments have
helped greatly — the centralizing of Treasury operations, particularly within large multina-
tionals, and the focus put on hiring specifically experienced and qualified personnel to manage
the day-to-day operations of risk management.
Before going on I would point out that perhaps to some reading this, it may seem strange
and slightly out of touch to be examining advanced approaches to the management of currency
risk at a time when the number of currencies worldwide seems to be rapidly diminishing. The
creation of the Euro-zone has eliminated a large number of western European currencies, with
the prospect that many countries within eastern Europe will enter it from 2004–5 onwards,

giving up their own currencies in the process. In the Americas, the creation of the North
American Free Trade Area has created a de facto US dollar bloc. Though some may not like
to see it that way, that is surely the reality and on the whole it has been a positive development.
As yet, the talk that there may be a unification of the US and Canadian dollars is just that, talk,
but who knows for the future? There is no such talk about unification with the Mexican peso,
as it is doubtful whether any Mexican administration that suggested any such would survive.
That said, there is little question that the economic impact of NAFTA appears to have added
greatly to the stability of the Mexican peso, rendering the question redundant for now. In Asia,
there are occasional mutterings that there could be a single currency, either in Asia as a whole
(i.e. the Japanese yen) or more specifically within the ASEAN region of countries. On the
first, any prospect of a pan-Asian currency seems far off, not least because a number of Asian
countries, notably China, would not accept the dominant role that any such currency would
automatically give Japan. In addition, given Japan’s slow economic descent in the 1990s, it is
questionable whether anyone in their right mind would want to unify their currencies with the
yen and thus by doing so import deflation. The more specific idea of an ASEAN currency is
a greater possibility, at least in relative terms, though it has not yet been raised to any serious
extent. Moreover, the idea of the Asian Free Trade Area (AFTA) has yet to see fruition. It
would probably be best to focus on that first, before considering a single currency area.
There is no question however that the number of national currencies is on a downtrend.
This may cause some to assume that the need for currency risk management should similarly
be on a downtrend. In fact, quite the opposite is the case. The desire of corporate executives
“just to be able to get on with the company’s underlying business” is a natural one, but it will
be some time — if ever — before they will be able to ignore currency risk. There may be a
single currency in the Euro-zone, but there is not worldwide — whatever we think of the role
of the US dollar — and there is unlikely to be any time soon. Even in the brave new world
of the Euro-zone, where currency risk should in theory be a thing of the past, it remains an
important consideration. To use John Donne, just as no man is an island, the same is true for the
corporation. Within the Euro-zone, currency translation and therefore direct currency risk has
been eliminated. However, corporations are still exposed to competitive threats from exchange
rate movements between the Euro-zone and the rest of the world. A single currency area such

as the Euro-zone can eliminate only one form of currency risk, that is the direct kind. However,
it cannot eliminate indirect currency risk for the very reason that the Euro-zone is but one area,
albeit an important one, within the global economy. National currencies still have to be dealt
with and that is unlikely to change near term.
7.1 CURRENCY RISK
So, what precisely is currency risk? There is no point in focusing on an issue if one cannot first
define it. Although definitions vary within the academic community, a practical description of
Managing Currency Risk I 139
currency risk would be:
The impact that unexpected exchange rate changes have on the value of the corporation
Currency risk is very important to a corporation as it can have a major impact on its cash flows,
assets and liabilities, net profit and ultimately its stock market value. Assuming the corporation
has accepted that currency risk needs to be managed specifically and separately, it has three
initial priorities:
1. Define what kinds of currency risk the corporation is exposed to
2. Define a corporate Treasury strategy to deal with these currency risks
3. Define what financial instruments it allows itself to use for this purpose
Currency risk is simple in concept, but complex in reality. At its most basic, it is the possible
gain or loss resulting from an exchange rate move. It can affect the value of a corporation
directly as a result of an unhedged exposure or more indirectly.
Different types of currency risk can also offset each other. For instance, take a US citizen
who owns stock in a German auto manufacturer and exporter to the US. If the Euro falls against
the US dollar, the US dollar value of the Euro-denominated stock falls and therefore on the
face of it the individual sees the US dollar value of their holding decline. However, the German
auto exporter should in fact benefit from a weaker Euro as this makes the company’s exports to
the US cheaper, allowing them the choice of either maintaining US prices to maintain margin
or cutting them further to boost market share. Sooner or later, the stock market will realize
this and mark up the stock price of the auto exporter. Thus, the stock owner may lose on the
currency translation, but gain on the higher stock price.
This is of course a very simple example and life unfortunately is rarely that simple. For

just as a weaker Euro makes exports from the Euro-zone cheaper, so it makes imports more
expensive. Thus, an exporter may not in fact feel the benefit of the currency translation through
to market share because higher import prices force it to raise export prices from where they
would otherwise would be according to the exchange rate.
The first step in successfully managing currency risk is to acknowledge that such risk actually
exists and that it has to be managed in the general interest of the corporation and the corpora-
tion’s shareholders. For some, this is of itself a difficult hurdle as there is still major reluctance
within corporate management to undertake what they see as straying from their core, under-
lying business into the speculative world of currency markets. The truth however is that the
corporation is a participant in the currency market whether it likes it or not; if it has foreign
currency-denominated exposure, that exposure should be managed. To do anything else is
irresponsible. The general trend within the corporate world has however been in favour of
recognizing the existence of and the need to manage currency risk. That recognition does not
of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined as the
elimination of speculation:
The real speculation is in fact not managing currency risk
The next step, however, is slightly more complex and that is to identify the nature and extent
of the currency risk or exposure. It should be noted that the emphasis here is for the most part
on non-financial corporations, on manufacturers and service providers rather than on banks
or other types of financial institutions. Non-financial corporations generally have only a small
amount of their total assets in the form of receivables and other types of transaction. Most of
their assets are made up of inventory, buildings, equipment and other forms of tangible “real”
assets. In order to measure the effect of exchange rate moves on a corporation, one first has to
140 Currency Strategy
define the type and then the amount of risk involved, or the “value at risk” (VaR). There are three
main types of currency risk that a multinational corporation is exposed to and has to manage.
7.2 TYPES OF CURRENCY RISK
1. Transaction risk (receivables, dividends, etc.)
2. Translation risk (balance sheet)
3. Economic risk (present value of future operating cash flows)

7.2.1 Transaction Risk
Transaction currency risk is essentially cash flow risk and relates to any transaction, such as
receivables, payables or dividends. The most common type of transaction risk relates to export
or import contracts. When there is an exchange rate move involving the currencies of such a
contract, this represents a direct transactional currency risk to the corporation. This is the most
basic type of currency risk which a corporation faces.
7.2.2 Translation Risk
Translation risk is slightly more complex and is the result of the consolidation of parent
company and foreign subsidiary financial statements. This consolidation means that exchange
rate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to the
parent company’s balance. Translation risk is thus balance sheet currency risk. While most
large multinational corporations actively manage their transaction currency risk, many are less
aware of the potential dangers of translation risk.
The actual translation process in consolidating financial statements is done either at the
average exchange rate of the period or at the exchange rate at the period end, depending on the
specific accounting regulations affecting the parent company. As a direct result, the consoli-
dated results will vary as either the average or the end-of-period exchange rate varies. Thus,
all foreign currency-denominated profit is exposed to translation currency risk as exchange
rates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidated
on the parent company’s balance sheet, and that value will vary accordingly. Translation risk
for a foreign subsidiary is usually measured by the net assets (assets less liabilities) that are
exposed to potential exchange rate moves.
Problems can occur with regard to translation risk if a corporation has subsidiaries whose
accounting books are local currency-denominated. For consolidation purposes, these books
must of course be translated into the currency of the parent company, but at what exchange
rate? Income statements are usually translated at the average exchange rate over the period.
However, deciding at what exchange rate to translate the balance sheet is slightly more tricky.
There are generally three methods used by major multinational corporations for translating
balance sheet risk, varying in how they separate assets and liabilities between those that need
to be translated at the “current” exchange rate at the time of consolidation and those that are

translated at the historical exchange rate:
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The all current (closing rate) method
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The monetary/non-monetary method
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The temporal method
As the name might suggest, the all current (closing rate) method translates all foreign currency
exposures at the closing exchange rate of the period concerned. Under this method, translation

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Managing Currency Risk I 141
risk relates to net assets or shareholder funds. This has become the most popular method
of translating balance exposure of foreign subsidiaries, both in the US and worldwide. On
the other hand, the monetary/non-monetary method translates monetary items such as assets,
liabilities and capital at the closing rate and non-monetary items at the historical rate. Finally,
the temporal method breaks balance sheet items down in terms of whether they are firstly

stated at replacement cost, realizable value, market value or expected future value, or secondly
stated at historic cost. For the first group, these are translated at the closing exchange rate of
the period concerned, for the second, at the historical exchange rate.
The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. Under
FAS 52, the translation of foreign currency revenues and costs is made at the average exchange
rate of the period. FAS 52 generally uses the all current method for translation purposes, though
it does have several important provisions, notably regarding the treatment of currency hedging
contracts. Under SSAP 20, the corporation can use either the current or average rate. Generally,
there has been a shift among multinational corporations towards using the average rather than
the closing rate because this is seen as a truer reflection of the translation risk faced by the
corporation during the period.
Translation risk is a crucial issue for corporations. Later in this chapter, we will look at
methods of hedging it. For now, it is important to get an idea of how it can affect the company’s
overall value.
Example
Take an example of a Euro-based manufacturer which has bought a factory in Poland. Needless
to say, the cost base in Poland is substantially below that of the parent company, one of several
major reasons why the acquisition was made in the first place. From 1999 to 2001, the Euro
was on a major downtrend, not just against its major currency counterparts but also against
most currencies of the Central and East European area, such as the Polish zloty. Thus we get
the following simple model:
EUR–USD ↓=EUR–PLN ↓
where:
EUR–USD = The Euro–US dollar exchange rate
EUR–PLN = The Euro–Polish zloty exchange rate
This is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a basket
of Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and thus
was unable to appreciate despite the ongoing decline in the value of the Euro across the board.
For another, it does not take account of EUR–PLN volatility. That said, general Euro weakness
has clearly been an important factor in the depreciation of the Euro–zloty exchange rate. Note

however that as the Euro–zloty exchange rate has depreciated for this and other reasons so the
value of the original investment in the Polish factory has increased in Euro terms. Thus:
EUR–PLN ↓=EUR translation value of Polish subsidiary ↑
Whatever our Euro-based manufacturer may think of Euro weakness, it is entirely beneficial
for the manufacturer’s translation value of the Polish factory/subsidiary when the financial
statements are consolidated at the end of the accounting period. The translation benefit to the
balance sheet will depend on the accounting method of translation. Conversely, were the Euro
ever to rally on a sustained basis, this might cause the Euro–zloty exchange rate to rally, thus in
142 Currency Strategy
turn reducing the translation value of the corporation’s Polish subsidiary. The consolidation of
financial statements would mean that this not only has an impact on the Euro value of the Polish
subsidiary but also on the balance sheet of the parent, Euro-based manufacturer. The risk of a
sudden balance sheet deterioration of this kind is not negligible where corporations have a broad
range of foreign subsidiaries, with accompanying transactional and translational currency risk.
7.2.3 Economic Risk
The translation of foreign subsidiaries concerns the consolidatedgroupbalance sheet. However,
this does not affect the real “economic” value or exposure of the subsidiary. Economic risk
focuses on how exchange rate moves change the real economic value of the corporation,
focusing on the present value of future operating cash flows and how this changes in line
with exchange rate changes. More specifically, the economic risk of a corporation reflects the
effect of exchange rate changes on items such as export and domestic sales, and the cost of
domestic and imported inputs. As with translation risk, calculating economic risk is complex,
but clearly necessary to be able to assess how exchange rate changes can affect the present
value of foreign subsidiaries. Economic risk is usually applied to the present value of future
operating cash flows of a corporation’s foreign subsidiaries. However, it can also be applied
to the parent company’s operations and how the present value of those change in line with
exchange rate changes.
Summarizing this part, transaction risk deals with the effect of exchange rate moves on transac-
tional exposure such as accounts receivable/payable or dividends. Translation risk focuses on
how exchange rate moves can affect foreign subsidiary valuation and therefore the valuation of

the consolidated group balance sheet. Finally, economic risk deals with the effect of exchange
rate changes to the present value of future operating cash flows, focusing on the “currency of
determination” of revenues and operating expenses. Here it is important to differentiate be-
tween the currency in which cash flows are denominated and the currency that may determine
the nature and size of those cash flows. The two are not necessarily the same. To complicate
the issue further, there is the small matter of the parent company’s currency, which is used to
consolidate the financial statements. If a parent company has foreign currency-denominated
debt, this is recorded in the parent company’s currency, but the value of its legal obligation
remains in the currency denomination of the debt. In sum, transaction risk is just the tip of the
iceberg!
Of necessity, the reality of currency risk is very case-specific. That said, there has been an
attempt by the academic and economic communities to apply the traditional exchange rate
models to the corporate world for the purpose of demonstrating how exchange rates impact a
corporation. More specifically, the models typically used for this purpose have been those of
PPP, the international Fisher effect and the unbiased forward rate theory, which we looked at
in Chapter 1. To recap:
r
PPP (or the law of one price) suggests that price differentials of the same good in different
countries require an exchange rate adjustment to offset them.
r
The international Fisher effect suggests that the expected change in the exchange rate is
equal to the interest rate differential.
r
The unbiased forward rate theory suggests that the forward exchange rate is equal to the
expected exchange rate.
Managing Currency Risk I 143
Generally, these theories are grounded in the efficient market hypothesis and therefore flawed
at best. Over the long term, these traditional “rules” of exchange rate theory suggest that
competition and arbitrage should neutralize the effect of exchange rate changes on returns and
on the valuation of the corporation. Equally, locking into the forward rate should, according to

the unbiased forward rate theory, offer the same return as remaining exposed to currency risk,
as this theory suggests that the distribution of probability should be equal on either side of the
forward rate.
The unfortunate thing about such models, however worthy the attempt, is that they do not
and cannot deal with the practical realities of managing currency risk. What academics regard
as “temporary deviations” from where the model suggests the exchange rate should be can
be sufficient and substantial enough to cause painful and intolerable deterioration to both the
P&L and the balance sheet.
To conclude this part, a corporation should define and seek to quantify the types of currency
risk to which it is exposed in order then to be able to go about creating a strategy for managing
that currency risk.
7.3 MANAGING CURRENCY RISK
Transactional currency risk can be hedged tactically or strategically by the corporate Treasury
to preserve cash flow and earnings, depending on their currency view.
Translational currency risk is usually hedged opportunistically rather than systematically,
notably to try to avoid emerging market-related shocks to net assets, usually focusing on either
long-term foreign investment or debt structure.
Hedging economic risk is complex, requiring the corporation to forecast its revenue and cost
streams over a given period and then to analyse the potential impact on these of an exchange
rate deviation from the rate used in calculating revenue and cost. For the debt structure, the
currency of denomination must be chosen, the amount of debt estimated in that currency and
the average interest period determined. The effect on cash flow should be netted out over
product lines and across markets. What’s left from this process is the economic risk that has
to be managed. For large multinationals, the net economic risk may in fact be quite small
because of offsetting effects. However, economic risk can be substantial for corporations that
have invested in only one or two foreign markets.
The first two steps of this process appear to have been accomplished. Firstly, we have defined
very specifically the types of currency risk that a corporation is exposed to. Secondly, we have
looked at broad strategy, the brushstrokes of managing that currency risk. Yet, while this
currency risk may be defined, it must also be quantified. Quantifying an amount of currency

may be easy for transaction risk, but for translation or economic risk it is no easy task. Just as
with other types of risk management, the most popular way of doing this is to use a “VaR” model.
7.4 MEASURING CURRENCY RISK — VAR AND BEYOND
Value at risk is defined as:
The maximum loss for a given exposure over a given time horizon with x% confidence
VaR helps a user to define the maximum loss on an exposure for a given confidence level
and has helped investors and corporations in managing their risk. VaR is on the face of it an
excellent risk management tool, which can be used to measure a variety of risk types.
144 Currency Strategy
However, it should be noted that:
VaR does not define the worst case scenario
It may give the maximum loss for an exposure with 99% confidence using a 3000-iteration
Monte Carlo simulation. The question remains however, what happens to the exposure for
that 1% point of confidence? The frank truth is a VaR model is incapable of answering that
question. Thus, a degree of both care and common sense is needed. The more sophisticated
corporate Treasuries frequently seek to refine their VaR model to go beyond the natural con-
fidence level limit to try and define the maximum loss with 100% confidence. A practical
way of trying to achieve this is to impose operational limits (such as in terms of number of
contracts, nominal amount, sensitivities or stop loss orders) in addition to VaR limits. That
relates to the aspect of care. The common sense aspect relates to never trusting your risk to a
computer model alone. If you cannot quantify it itself without use of the model, you have a
problem.
7.5 CORE PRINCIPLES FOR MANAGING CURRENCY RISK
So far we have examined currency risk, how to manage and quantify it. Before we go on
from theory into practice, it may well be useful to establish a framework, a reference for
corporate Treasury of core principles of managing currency risk. There have been several
notable efforts along these lines, most notably of course the “Core Principles of Managing
Currency Risk” set out by the Group of 31 (US multinational corporations) and Greenwich
Treasury Advisors.
Clearly, there is a danger in attempting anything even approaching best practice for corporate

Treasury as corporations vary so significantly in terms of their exposures, requirements and
focus. Such concerns notwithstanding, the importance of the issue equally requires that the
attempt be made to create a reference from which individual corporations can perhaps take
what might be appropriate to them. Thus, what follows is my own tentative suggestion of what
any such list of core principles of managing currency risk should contain:
1. Determine the types of currency risk to which the corporation is exposed — Break
these down into transaction, translation and economic risk, making specific reference to
what currencies are related to each type of currency risk.
2. Establish a strategic currency risk management policy — Once currency risk types have
been agreed on, corporate Treasury should establish and document a strategic currency
risk management policy to deal with these types of risks. This policy should include the
corporation’s general approach to currency risk, whether it wants to hedge or trade that risk
and its core hedging objectives.
3. Create a mission statement for Treasury — It is crucial to create a set of values and princi-
ples which embody the specific approach taken by the Treasury towards managing currency
risk, agreed upon by senior management at the time of establishing and documenting the
risk management policy.
4. Detail currency hedging approach — Having established the overall currency risk man-
agement policy, the corporation should detail how that policy is to be executed in practice,
including the types of financial instruments that could be used for hedging, the process by
which currency hedging would be executed and monitored and procedures for monitoring
and reviewing existing currency hedges.
Managing Currency Risk I 145
5. Centralizing Treasury operations as a single centre of excellence — Treasury operations
can be more effectively and efficiently managed if they are centralized. This makes it
easier to ensure all personnel are clear about the Treasury’s mission statement and hedging
approach. Thus, the Treasury can be run as a single centre of excellence within the corpora-
tion, ensuring the quality of individual members. Large multinational corporations should
consider creating a position of chief dealer to manage the dealing team, as the demands of a
Treasurer often exceed the ability to manage all positions and exposures on a real-time basis.

The currency dealing team must have the same level of expertise as their counterparty banks.
6. Adopt uniform standards for accounting for currency risk — In line with the central-
izing of Treasury operations, uniform accounting procedures with regard to currency risk
should be adopted, creating and ensuring transparency of risk. Create benchmarks for
measuring the performance of currency hedging.
7. Have in-house modelling and forecasting capacity — Currency forecasting is as
important as execution. While Treasury may rely on its core banks for forecasting exchange
rates relative to its needs, it should also have its own forecasting ability, linked in with
its operational observations which are frequently more real time than any bank is capable
of. Treasury should also be able to model all its hedging positions using VaR and other
sophisticated modelling systems.
8. Create a risk oversight committee — In addition to the safeguard of a chief dealer position
for larger multinational corporations, a risk oversight committee should be established
to approve position taking above established thresholds and review the risk management
policy on a regular basis.
Clearly, this list of core principles of managing currency risk is aimed at the larger multina-
tional corporations that have the means and the business requirements for such a sophisticated
Treasury operation. That said, such a list can also be used as a benchmark for those who, while
they cannot or do not need to comply with all elements, can still find some useful. Corporations
of whatever size and sophistication must balance the real cost of implementing such an ap-
proach to managing currency risk against the possible cost of not doing so. The first cost is
tangible, the second intangible — but by the time the second becomes tangible it is too late!
That is precisely what we are trying to avoid.
It may be useful for a corporation to split currency risk management into two parts — the
first part focusing on the overall approach towards managing of currency risk, the second
dealing with the actual execution of currency risk management. Many corporations have this
kind of division of labour, whether or not they formalize it. However rigorous a currency
risk management policy is, it still runs the risk of being bypassed by events, technology and
innovation. Thus, it is very important to have a regular review process to ensure the currency
risk management policy remains up-to-date and in line with the corporation’s needs. In this

review process, important questions to be raised may include:
r
Do the currency risk management policy and the Treasury’s mission statement still represent
the corporation’s business needs? Should the corporation maintain or change its approach
towards managing currency risk?
r
How has currency hedging performed relative to the established benchmarks? How can the
costs of currency hedging be reduced?
r
Are VaR or credit limits, or the financial instruments relating to currency risk management,
still appropriate?

@Team-FLY
146 Currency Strategy
7.6 HEDGING — MANAGEMENT RELUCTANCE
AND INTERNAL METHODS
Having looked in detail at the issue of managing currency risk, we should now be looking

at the specifics of how to hedge that risk. Before we do that, we first have to examine the
issue of management reluctance to hedge a risk many see as merely an operational hazard
of international investment. Some may dismiss this section, either because it is irrelevant to
them or because they view any such approach as inappropriate. While I too share the view
that currency risk should be managed, such management reluctance should not be ignored, but
instead should be understood and thereafter combated. Three key reasons for this reluctance
which come up time and again are the following:
r
Management does not understand active currency management methods
r
Management thinks currency risk cannot be measured accurately
r
Management sees active currency management as outside of core business
Some of these points are reasonable. Currency forwards and options may well be outside
the field of expertise of a corporation’s management, and will certainly be outside the core
business operations. Many managements consider such financial instruments as speculative.
However, it is the job of Treasury to explain that not managing currency risk actively leaves the
corporation vulnerable to major exchange rate movements, which can cause substantial swings
in the company’s value. Using forwards or options may indeed be speculative, depending on
what they are used for. However, not hedging currency risk may be even more speculative.
Active currency management is a necessary byproduct of a corporation’s overseas investments
and operations. Again, it is the job of the Treasury to educate the management and ultimately
the board on the need for active currency management, not least to maintain and ensure the
corporation’s equity market value. A corporation may not be able to boost shareholder value
significantly through active currency risk management, but it can certainly damage it by not
managing currency risk.
When management says it is difficult to measure currency risk it is correct, but that does
not mean such risk cannot be quantified. Imprecision is not an excuse for indecision in the
corporation’s underlying business. Neither should it be tolerated with regard to currency risk
management.

Even if a management is willing to consider currency hedging, there are ways of “natural”
or internal hedging that it may consider first, such as:
r
Netting (debt, receivables and payables are netted out between group companies)
r
Matching (intragroup foreign currency inflows and outflows)
r
Leading and lagging (adjustment of credit terms before and after due date)
r
Price adjustment (raising/lowering selling prices to counter exchange rate moves)
r
Invoicing in foreign currency (this cuts out transactional exposure)
r
Asset/liability management (for balance sheet, income or cash flow exposure)
Netting involves the settling of intragroup debt, receivables and payables for the net amount.
The simplest form of this is bilateral netting between two affiliates.
Matching is similar but can be applied both to intragroup and third-party flows. Here, a
corporation “matches” its foreign currency inflows and outflows with respect to amount and
timing.
Managing Currency Risk I 147
Leading and lagging refer to adjusting credit terms between group companies, where
“leading” means paying an obligation in advance of the due date and “lagging” means after the
due date. This is a tactic aimed at capturing expected currency appreciation or depreciation.
Price adjustment involves increasing selling prices to counter exchange rate moves.
Invoicing in foreign currency reduces transaction risk relating specifically to exports and
imports.
Asset and liability management can be used to manage the balance sheet, income statement
or cash flow exposure. Corporations can adopt either an active or a passive approach to asset
and liability management, depending on their currency and interest rate risk management
policy.

Finally one can hedge internally by increasing corporate gearing. Leverage shields corpo-
rations from taxes because interest is tax-deductible whereas dividends are not. However, the
extent to which one can increase gearing or leverage is limited by costs. That said, if currency
hedging reduces taxes, shareholders benefit.
For practical purposes, three questions capture the extent of a corporation’s currency risk:
1. How quickly can a corporation adjust prices to offset exchange rate impact on profit
margins?
2. How quickly can a corporation adjust sources for inputs and markets for outputs?
3. To what extent do exchange rate moves have an impact on the value of assets?
Within a corporation, it is usually the case that those who can come up with the best answers to
these questions are directly involved in such tasks as purchasing and production. Thus, finance
executives who focus exclusively on the credit and currency markets can in fact miss the real
essence of a corporation’s currency risk. Furthermore, the exact answers to these questions
need to be known not only by the oversight or risk committee, but preferably by the CEO
as well. If they don’t, they effectively don’t know both the value and the exposure of the
corporation.
7.7 KEY OPERATIONAL CONTROLS FOR TREASURY
Assuming the corporation has accepted the need to manage currency risk, appointed a risk or
oversight committee and in the case of large multinational corporations a chief dealer as well,
it needs then to establish a set of operational controls in order to be able to monitor that risk and
ensure inappropriate positions are not being taken. The importance of doing this is underlined
every time the news headlines show another corporation has lost millions of pounds, dollars or
yen by not putting such controls in place, or rather by not ensuring their enforcement. There
are other operational controls that are important, but among the key ones to put in place are
the following:
r
Position limits — Positions above a certain limit or threshold should not be undertaken
without the written authorization of the chief dealer, Treasurer, oversight committee and the
board.
r

Position monitoring — Treasury must have the technological and manpower capability to
monitor and mark-to-market all the currency and interest rate positions it has taken on at
any one time.
r
Performance benchmarks should be established — For corporations that only participate
in the currency market for hedging purposes, currency hedging benchmarks should be
148 Currency Strategy
established. For those that are allowed to trade in the currency market, a trading budget
should be established at the start of the year and the performance monitored on a monthly
or quarterly basis.
7.8 TOOLS FOR MANAGING CURRENCY RISK
The board has given Treasury free rein to manage the corporation’s currency risk within the
parameters set out in the currency risk management policy. Within that policy, there should
be a section on what financial instruments can be used for this purpose. Hedging currency
risk in no longer a simple matter of using vanilla forwards and options. As the needs of the
modern corporation have changed, so the tools or structures for hedging that risk have changed
accordingly, consisting of ever greater specificity and flexibility to meet those needs. Most of
the development within this field has happened in financial options, given the more flexible
nature of the option instrument relative to the forward. Thus, I present a pair of tables looking
for the most part at the types of option structures that corporations are using today, breaking
these down into “traditional” (Table 7.1) and “enhanced” (Table 7.2) structures, relating to
their degree of sophistication.
Table 7.1 Traditional hedging structures
Instrument Definition Advantages Disadvantages
Plain vanilla
call
Buy an upside strike in an
exchange rate with no
obligation to exercise
Simplicity, cheaper than

the forward and the
maximum loss is the
premium
Higher cost than more
sophisticated structures
Plain vanilla
forward
Buy a currency contract
for future delivery at a
price set today
You are 100% hedged High cost and risk of the
exchange rate moving
against you
Call spread Buy an at-the-money call
(ATMF) and sell a low
delta call
Lower cost than a vanilla
call
Allows cover only for
modest exchange rate
appreciation as dictated
by strikes
Calendar
spread
Buy a 3M call and sell a
1M call (of the same
delta)
Allows you to capture a
timing view on FX
moves

Leaves you vulnerable to
adverse moves in one of
the legs
Risk rever-
sal
Buy a 25 delta call, sell a
25 delta put
Risk reversals capture the
market’s “skew” thus
they offer buying/
selling opportunity
relative to historical risk
reversals; can be
structured to be low or
zero cost
Writing the 25 delta put
leaves you vulnerable to
an adverse move in spot
which may cause a
spike higher in vol not
offset by the higher vol
in the call
“Seagull” Buy an ATMF call, sell a
low delta call and sell a
downside put
Can be structured to be
zero cost
Unless structured in a
ratio, leaves you net
short vol; not covered

against a major spot
move
Managing Currency Risk I 149
Table 7.2 Enhanced hedging structures
Instrument Definition Advantages Disadvantages
Knock-out Buy a 30 delta call
with a downside
knockout
(down-and-out)
Reduces cost of call;
lets you re-hedge
lower down in the
exchange rate
If knocked-out you
are not hedged and
vulnerable to an
adverse FX move
Knock-in Buy a 30 delta call
with upside
knock-in
(up-and-in)
Reduces the cost;
you are not hedged
until knocked-in
If knocked-in, you
are then
vulnerable to a
spot reversal
Range binary Buy a double
knock-out

Gives you leverage
premium,
expecting range
trading
If knocked-out, you
will have to
re-hedge
Window option Buy the right to buy
a 30 delta call in a
given number of
periods
Lets your currency
view be “wrong” a
number of times
Higher cost than the
vanilla call
Fade-in option Buy a 30 delta call
and fade into the
call incrementally
over a given
period of time
Allows you to “fade
in” to the call for a
period, thus giving
you more cost and
time flexibility
If spot moves while
you are fading in,
you do not capture
as much of the

move as with a
vanilla call
Convertible forward Buy a call, sell a
down-and-in put
Converts to forward
at agreed rate;
client can take
advantage of a
contrarian move in
spot up to the KI
The strike is more
expensive than the
forward and must
be paid if structure
is knocked-in
Enhanced forward Buy an up-and-in–
down-and-in
call/sell an
up-and-in–down-
and-in put; buy an
up-and-out–down-
and-out call/buy
an up-and-out–
down-and-out
put
If the currency stays
within an agreed
range, the rate is
significantly
improved relative

the vanilla forward
If spot goes outside
of the range, the
forward rate to be
paid becomes
more expensive
Cross-currency coupon swap Buy a currency swap
and at the same
time pay fixed and
receive floating
Lets you manage FX
and interest rate
risk in markets
suited to the
corporation
Leaves the buyer
vulnerable to both
currency and
interest rate risk
Cross-currency basis swap Buy a currency
swap, at the same
time pay floating
interest in a
currency and
receive floating in
another
Currency risk is the
same as a standard
currency swap, but
the basis currency

swap allows you
to capture interest
rate differentials
The risk in this
structure is interest
rate risk rather
than currency risk
150 Currency Strategy
7.9 HEDGING STRATEGIES
7.9.1 Hedging Transaction Risk
The unbiased forward rate theory suggests the expected spot exchange rate is the forward
rate. If this worked, it would mean that failing to hedge currency risk would yield similar
results in the long run to hedging. There are two problems with this. First, the Treasurer would
probably be fired before the “long run” arrived. Second, the unbiased forward rate theory is
a poor predictor of future exchange rates in practice. Basically it does not work. Therefore,
a corporation should use market-based currency forecasting in addition to the forward rate
to predict future exchange rates. The discretionary aspect to the currency forecast means the
corporation has the choice of hedging:
r
Tactically and selectively
r
Strategically
r
Passively
Corporations vary in their attitude towards transaction hedging. Some hedge passively, that
is to say they maintain the same hedging structure and execute over regular periods during
the financial year. This type of transaction hedging does not involve the corporation “taking a
(currency) view”. The other two types of hedging strategy do indeed involve taking a currency
view. Strategic hedging involves the corporation taking a view for a longer period than imme-
diate transaction receivables and payables might require. In January 1999, I remember wave

after wave of European corporations hedging both developed and emerging market currency
risk as far out as one year. Corporations who usually called in USD20–30 million to hedge
very short-term receivables were calling for prices in a number of emerging market currency
pairs in USD200–300 million. The Russian crisis of August 1998 and the collapse of LTCM
had clearly scared global financial markets. With the threat looming of devaluation in Brazil
(which indeed happened in January 1999), many European corporations were apparently tak-
ing advantage of the relaxation in global market tensions and reduced risk premiums in the
market in the wake of the Fed’s extraordinary monetary easing of August and September,
with three interest rate cuts in quick succession to hedge their transactional currency risk as
far out as they could go. That is an example of strategic hedging. Finally, tactical and selec-
tive hedging of transactional currency risk is the usual business that a corporate dealing desk
does with its clients. A bank’s clients may choose to allow certain currency exposures to be
translated at the period end, and others they may choose to hedge, depending crucially on
their currency view. Typically, it makes sense for a corporation to use the tactical and selec-
tive approach for most transactional currency risks and only occasionally to pull the trigger
on strategic hedging should the need arise. While passive hedging may appeal to some, it
hurts flexibility, not only with regard to the hedging strategy but also with regard to domestic
pricing.
7.9.2 Hedging the Balance Sheet
While corporate Treasury is usually active in hedging transaction currency risk, it rarely con-
siders translation risk — or hedging the balance sheet. This is largely because balance sheet
risk is largely made up of foreign direct investment or the debt structure of the corporation. In
the first case, the management has a natural and instinctive objection to the idea of hedging

@Team-FLY
Managing Currency Risk I 151
the balance sheet risk, involving a direct investment abroad, since that would seem to negate
the reason for the initial investment. For this very reason, many corporations do not hedge
translation or balance sheet risk because of:
r
The long-term nature of their investments in subsidiaries
r
The perceived zero-sum nature of currency risk over the long term
r
Accounting and tax issues
r
Cash flow impacts
A further disincentive is that currency translation affects the balance sheet rather than the
income statement, which may make it less of an immediate priority for management. Equity
analysts tend to focus on EBIT (or EBITDA) before debt/equity ratios. Eventually, however,
the deterioration in balance sheet ratios can impact the corporation’s average cost of capital
and ultimately its valuation in the market place.
Example
European exporters with US subsidiaries have seen two major benefits as a result of the Euro’s
weakness against the US dollar over the last two years. Firstly, at the direct level, this Euro
weakness has made their exports cheaper to the US, allowing them to lower export prices and
thus gain market share. Secondly, Euro weakness has, just as we saw with the previous Polish

example, boosted the Euro value of their US subsidiaries. At some stage, the Euro’s decline
against the dollar may reverse. How would the corporate Treasury best cope with this? The
export question concerns transaction exposure. The question of the subsidiary’s value when
translated back into Euros is one of translation currency risk or exposure. In this case, both
types of “polar” hedge — zero or 100% hedged — seem inappropriate. The risk of the Euro
rallying on a sustained basis against the dollar may be seen by many as small, but it is not
zero. Therefore it would be inappropriate to have a zero-rate balance sheet hedge to cover
the risk of valuation loss in the subsidiary. On the other hand, it would also seem extreme
to hedge 100% of the subsidiary’s value. A neat way round this dilemma might be to use a
variable hedge ratio for net balance sheet exposures, which are triggered by the interest rate
differential. Remember that when hedging balance sheet risk, what you are hedging is the net
assets (gross assets less liabilities) of the subsidiary or subsidiaries that may be affected by
an adverse exchange rate move. Thus, important considerations are the financing, net cash
flows and intangibles relating to those subsidiaries. The corporation’s debt structure is also
an important consideration. Corporations with higher local tax rates tend to debt finance their
investments in order to reduce their average cost of capital.
There are two parts to this issue however. Up to now, we have looked at the idea of hedging
the risk within the consolidated balance sheet relating to foreign investment. The other part of
this issue relates to the corporation’s debt profile. The risk this represents is broadly affected by
the debt’s currency and maturity composition. The corporation can change this currency and
maturity composition to reduce the degree to which exchange rates are able to cause volatility
in net equity and earnings. Optimization can be used for this purpose, though this will not
completely eliminate currency risk and tactical hedging may be needed in addition.
There is no question that hedging balance sheet risk is more easily quantifiable than is
the case with economic risk. That said, hedging the remaining currency exposure after you
optimize the debt composition remains a controversial subject because it can be expensive, the
corporation may regret the decision to hedge if exchange rates do not move in the anticipated